Analyzing Financial Statements | Ratio Analysis

Ratio analysis is a more sophisticated technique for analyzing financial statements, if compared to horizontal analysis.

There are many ratios that could be calculated. However, I will only go through 4 types of ratios. These are the profitability ratios, management efficiency ratios, financial stability ratios and investment ratios.

It is important to choose the ratios relevant to the information you want to analyze. For example, the managers of a company would likely be interested in all the ratios. However, the shareholders and investors are likely to be more interested in the investment and profitability ratios. Creditors and lenders are more interested in the financial stability of the company.

The key in ratio analysis is to never stop asking questions.

• What does the ratio literally mean?
• What does a change in the ratio mean?
• What is the norm?
• What are the limitations of the ratio?

If you are not familiar with financial statements, read this article on understanding financial statements before you continue reading.

Profitability Ratios

The common profitability ratios are Return on Assets (ROA), Gross Profit Margin (GP margin), and EBIT margins.

ROA aims to measure how efficiently the business is using its resources. If a business has very low ROA, it may be better off selling off all its assets and invest the money into a high interest bearing account. Furthermore, a low return could become a loss if the business suffers a downturn.

Compare the current year ROA with previous years’ ROAs. Is the return increasing? Keep in mind that the non-current assets will have a lower value each year as the company depreciates its assets. This will result in a higher ROA if everything else remain unchanged.

Compare the ROA with the company’s target rate of return. Has the management achieved the target return? Are there certain business segments of the company under-performing thereby dragging the overall performance of the company? What solutions does the management have?

Compare the ROA with other companies within the same industries. However, you should be careful when comparing with other companies since other companies would have different accounting policies and assets age.

The GP margin should be expected to remain fairly constant over the years. Changes in the GP margin can be attributed to changes in selling prices, sales mix, product costs, and inventory valuation.

Companies dealing with mass products and commodities usually have low margins whereas companies dealing with high end, niche products have higher margins. Therefore to avoid confusion you should compare the GP margin with other companies within the same business sector.

Low margins usually suggest poor performance. However, it could also be due to expansion costs such as launching of a new product or trying to increase market share.

Above average margins are usually a sign of good management. It could also mean the presence of an economic moat.

The EBIT margin is affected by more factors than the GP margin. Compare with previous years’ EBIT margin. Improvement in EBIT margins could be due to improvement in GP margins or improvement in managing the operating costs.

Compare the EBIT margin with other companies within the same business sector. Is it higher, or lower?

Management Efficiency Ratios

Some common management efficiency ratios are Inventory Turnover, Inventory Days, Accounts Receivable Days and Accounts Payable Days.

Inventory turnover measures the multiple times the inventory is sold.

Companies such as Dell which practice virtually zero inventory holding will have very high turnover. Expect mass products to have high inventory turnover as well.

On the other hand, companies specializing in niche or luxurious products will have a lower inventory turnover. However, they make up for it by having a high GP margin.

Inventory days measures how efficiently the inventory is managed. Inventory days is different for different industries. For perishables, inventory days could be a few days, whereas for a manufacturer it could be 60 days or more depending on the complexity and time it takes to manufacture the goods.

Increasing inventory days implies that inventory is not moving quickly. It could be bad or good depending on the reasons for the increase. Possible reasons could be:

• lack of demand for the products.
• poor inventory control.
• inventory could be obsolete and hence may have to be written-off.
• management is taking advantage of bulk discounts, therefore buying inventory in larger quantities.
• stocking up inventory to avoid shortages, possibly in anticipation of a sales promotion in the near future (for finished goods) or a drop in supply by the suppliers (for raw materials).

Accounts Receivable Days measure how efficiently the company manages its accounts receivables. An increasing Accounts Receivable Days could be bad or good. Possible reasons are:

• lack of proper credit control.
• bad debt not fully written-off.
• deliberately extend the credit period to attract more sales.

Accounts Payable Days measure how efficiently the company manages its accounts payables. Possible reasons for an increase in accounts payable days are:

• longer repayment period due to extended credit period provided by suppliers.
• longer repayment period due to cash flows problems. Verify with the Statement of Cash Flows, Cash and Cash Equivalent balance in the balance sheet and the AR Days.

A repayment period that is too long may earn the company a reputation of being a bad paymaster and strain relationships with suppliers. The company could also lose out on worthwhile cash discounts.

Financial Stability Ratios

Current ratio and the quick ratio are short-term financial stability ratios. The gearing ratio and interest cover are long-term financial stability ratios.

Since current assets and current liabilities mature within 1 year, therefore the current ratio measures if the company has enough short-term resources to meet its short-term payments.

A current ratio of 1 suggests that the company has just enough resources to cover its short-term obligations.

Traditionally, a current ratio of at least 2 was considered as appropriate for most businesses to maintain creditworthiness. However, a current ratio that is too high for should be viewed with suspicion. It may be due to high levels of inventory and receivables (implies poor working capital efficiency) or high level of cash which could be put to better use than sitting around in the bank.

The idea behind Quick Ratio (aka Acid Test Ratio) is that inventory may not be easily turned into cash fast enough to settle immediate liabilities. Furthermore, inventories could sell for less than its costs in a fire sale.

Care should be taken when interpreting the Quick Ratio. A company with low quick ratio may have no problems settling its immediate liabilities if it has enough overdraft facilities available to draw upon.

The gearing ratio measures the proportion of assets in the company that is NOT financed by shareholders’ equity. If the gearing ratio is 1, this means that all the assets in the company are financed by borrowings and non-equity shares. There is zero shareholder equity.

If the gearing ratio is 0.6, this means that 60% of the assets are financed by borrowings and non-equity shares and 40% by shareholders’ equity.

A higher gearing ratio implies higher risk and therefore the stock price will be more volatile. If you are risk averse, you may want to consider avoiding companies with high gearing.

In the previous example of Optimus and Megatron, the risk lover may be inclined to invest in a company with high gearing anticipating high returns. However, you should consider the gearing ratio together with the interest cover.

The interest cover measures how many times the earnings of a company is able to cover its fixed obligation.

If interested cover is 1, then the company is earning just enough to pay its fixed obligation. A low interest cover may not be sufficient to ride out a sudden downturn. And if the business is not earning enough to pay interests to the lenders, the lenders could seize the company assets used for collateral or file for liquidation.

Investment Ratios

Some popular investment ratios are Earnings Per Share (EPS), Price/Earnings ratio (P/E) and Earnings Yield.

EPS measures the profitability of the business. EPS is popular because it is easy to understand and also because it is one of the components used to value the price of a share.

An increasing EPS is seen as a good sign. However, EPS could reduce if there was a bonus stock issue during the year. If EPS has reduced, you should verify the reasons for the reduction with the ROA and EBIT margin.

The P/E ratio is the most widely used investment ratio in the stock market. The P/E ratio is also known as an earnings multiple.

The P/E ratio reflects how many times the investor is willing to pay over the earnings of a share. If the market price is $1.50 and the EPS is $0.15, the P/E ratio works out to be 10. This implies that the investors are willing to pay up to 10 times more than its earnings.

Compare the P/E ratio with other companies within the same industries and previous years’ ratios. If the P/E ratio is lower, this could mean the company is undervalued than its real worth. However, it could also mean that the investors value this company lower than its competitors and they could be correct.

Different business sectors have different P/E ratios. The P/E ratio could be higher during economic boom and lower during downturn.

In summary, you should analyze the company financial performance, efficiency and stability by considering all the quantitative and qualitative information available. Qualitative information from the press release, directors’ statements, consumer trend, industry reports and others can support or discredit your findings from the ratio analysis.

You can compare the Return On Investment (ROI) of the stock with other investments using the Earnings Yield. Earnings yield is simply and inverted P/E.

If a stock has a P/E of 25, then the Earnings Yield is 1/25 which is 4%. You can compare this 4% with other types of investment to see which gives you a better ROI.

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